11ch22

22 - 1©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster
Management Control Systems,
Transfer Pricing, and
Multinational Considerations
Chapter 22

Learning Objective 1
Describe a management
control system and its
three key properties.

Management Control Systems
A management control system is a means
of gathering and using information.
It guides the behavior of managers and employees.

Management Control Systems
Financial data
Formal control system
Nonfinancial data
Informal control system

Evaluating Management
Control Systems
Motivation Goal congruence Effort
Lead to rewards
Monetary Nonmonetary

Describe the benefits and
costs of decentralization.

Organization Structure
Total decentralization
Total centralization

Benefits of Decentralization
Creates greater responsiveness to local needs
Leads to gains from quicker decision making
Increases motivation of subunit managers
Assists management development and learning
Sharpens the focus of subunit managers

Costs of Decentralization
Suboptimal decision making may occur
Focuses the manager’s attention on the subunit
rather than the organization as a whole
Increases the costs of gathering information
Results in duplication of activities

Decentralization in
Multinational Companies
Decentralization enables country managers to
make decisions that exploit their knowledge
of local business and political conditions.
Multinational corporations often rotate
managers between foreign locations
and corporate headquarters.

Responsibility Centers
Cost
center
Revenue
center
Investment
center
Profit
center

Explain transfer prices and four
criteria used to evaluate them.

Transfer Pricing
A transfer price is the price one subunit charges
for a product or service supplied to another
subunit of the same organization.
Intermediate products are the products
transferred between subunits of an organization.

Transfer Pricing
Transfer pricing should help achieve
a company’s strategies and goals.
– fit the organization’s structure
– promote goal congruence
– promote a sustained high level
of management effort

Calculate transfer prices using
three different methods.

Transfer-Pricing Methods
Market-based transfer prices
Cost-based transfer prices
Negotiated transfer prices

Transfer-Pricing
Methods Example
Lomas & Co. has two divisions:
Transportation and Refining.
Transportation purchases
crude oil in Alaska and
sends it to Seattle.
Refining processes
crude oil
into gasoline.

Transfer-Pricing
Methods Example
External market price for supplying
crude oil per barrel: $13
Transportation Division:
Variable cost per barrel of crude oil $ 2
Fixed cost per barrel of crude oil 3
Total $ 5
The pipeline can carry 35,000 barrels per day.

Transfer-Pricing
Methods Example
External purchase price for
crude oil per barrel: $23
Refining Division:
Variable cost per barrel of gasoline $ 8
Fixed cost per barrel of gasoline 4
Total $12
The division is buying 20,000 barrels per day.

Transfer-Pricing
Methods Example
The external market price to outside
parties is $60 per barrel.
The Refining Division is operating
at 30,000 barrels capacity per day.

Transfer-Pricing
Methods Example
What is the market-based transfer price
from Transportation to Refining?
$23 per barrel
What is the cost-based transfer price
at 112% of full costs?

Transfer-Pricing
Methods Example
Purchase price of crude oil $13
Variable costs per barrel of crude oil 2
Fixed costs per barrel of crude oil 3
Total $18
1.12 × $18 = $20.16
What is the negotiated price?
Between $20.16 and $23.00 per barrel.

Transfer-Pricing
Methods Example
Assume that the Refining Division buys
1,000 barrels of crude oil from the
Transportation Division.
The Refining Division converts these 1,000
barrels of crude oil into 500 gallons of
gasoline and sells them.
What is the Transportation Division operating
income using the market-based price?

Transfer-Pricing
Methods Example
Revenues: ($23 × 1,000) $23,000
Deduct costs: ($18 × 1,000) 18,000
Operating income $ 5,000
What is the Refining Division’s operating
income using the market-based price?

Transfer-Pricing
Methods Example
Refining Division:
Revenues: ($60 × 500) $30,000
Deduct costs:
Transferred-in ($23 × 1,000) 23,000
Division variable ($8 × 500) 4,000
Division fixed ($4 × 500) 2,000

Transfer-Pricing
Methods Example
What is the operating income of both
divisions together?
Transportation Division $5,000
Refining Division 1,000
Total $6,000

Transfer-Pricing
Methods Example
What is the Transportation Division’s operating
income using the 112% of full cost price?
Revenues: ($20.16 × 1,000) $20,160
Deduct costs: ($18.00 × 1,000) 18,000
What is the Refining Division operating
income using the full cost price?

Transfer-Pricing
Methods Example
Refining Division:
Revenues ($60 × 500) $30,000
Deduct costs:
Transferred-in ($20.16 × 1,000) 20,160
Division variable ($8.00 × 500) 4,000
Division fixed ($4.00 × 500) 2,000

Transfer-Pricing
Methods Example
What is the operating income of both
divisions together?
Transportation Division $2,160
Refining Division 3,840
Total $6,000

Illustrate how market-based
transfer prices promote goal
congruence in perfectly
competitive markets.

Market-Based Transfer Prices
By using market-based transfer prices
in a perfectly competitive market, a
company can achieve the following:
Goal congruence
Management effort
Subunit performance evaluation
Subunit autonomy

Market prices also serve to evaluate the
economic viability and profitability
of divisions individually.

When supply outstrips demand, market prices
may drop well below their historical average.
Distress prices are the drop in prices
expected to be temporary.

Avoid making suboptimal
decisions when transfer
prices are based on full
cost plus a markup.

Cost-Based Transfer
Prices Example
The Refining Division of Lomas & Co. is
purchasing crude oil locally for $23 a barrel.
The Refining Division located an independent
producer in Alaska that is willing to sell 20,000
barrels of crude oil per day at $17 per barrel
delivered to the pipeline (Transportation Division).

Cost-Based Transfer
Prices Example
The Transportation Division has excess
capacity and can transport the crude oil
at its variable costs of $2 per barrel.
Should Lomas purchase from the
independent supplier?
Yes.
There is a reduction in total costs of $80,000.

Cost-Based Transfer
Prices Example
Alternative 1:
Buy 20,000 barrels from the
local supplier at $23 per barrel.
The total cost to Lomas is:
20,000 × $23 = $460,000

Cost-Based Transfer
Prices Example
Alternative 2:
Buy 20,000 barrels from the independent
supplier in Alaska at $17 per barrel and
transport it to Seattle at $2 per barrel.
The total cost to Lomas is:
20,000 × $19 = $380,000

Cost-Based Transfer
Prices Example
Suppose the Transportation Division’s
transfer price to the Refining Division
is 112% of full cost.
What is the cost to the Refining Division?

Cost-Based Transfer
Prices Example
Purchase price of crude oil $17
Variable costs per barrel of crude oil 2
Fixed costs per barrel of crude oil 3
Total $22
1.12 × $22 = $24.64
$24.64 × 20,000 = $492,800

Cost-Based Transfer
Prices Example
What is the maximum transfer price?
It is the price that the Refining Division can
pay in the local external market ($23).
What is the minimum transfer price?
The minimum transfer price is $19 per barrel.

Understand the range over
which two divisions negotiate
the transfer price when
there is unused capacity.

Prorating
Lomas & Co. may choose a transfer price
that splits on some equitable basis the
difference between the maximum transfer
price and the minimum transfer price.
$23 – $19 = $4
Suppose that variable costs are chosen as
the basis to allocate this $4 difference.

Prorating
The Transportation Division’s variable
costs are $2 × 1,000 = $2,000.
The Refining Division’s variable costs to
refine 1,000 of crude oil into 500 barrels
of gasoline are $8 × 500 = $4,000.

Prorating
The Transportation Division gets to keep
$2,000 ÷ $6,000 × $4 = $1.33.
The Refining Division gets to keep
$4,000 ÷ $6,000 × $4 = $2.67.
What is the transfer price from the
Transportation Division?
$17.00 + $2.00 + $1.33 = $20.33

Dual Pricing
An example of dual pricing is for Lomas & Co.
to credit the Transportation Division with
112% of the full cost transfer price of $24.64
per barrel of crude oil.
Debit the Refining Division with the market-based
transfer price of $23 per barrel of crude oil.

Negotiated Transfer Prices
Negotiated transfer prices arise from the
outcome of a bargaining process between
selling and buying divisions.

Construct a general guideline
for determining a minimum
transfer price.

Comparison of Methods
Achieves Goal Congruence
Market Price: Yes, if markets competitive
Cost-Based: Often, but not always
Negotiated: Yes

Useful for Evaluating Subunit Performance
Cost-Based:
Difficult, unless transfer
price exceeds full cost
Negotiated: Yes

Motivates Management Effort
Market Price: Yes
Cost-Based:
Yes, if based on budgeted
costs; less incentive if
based on actual cost
Negotiated: Yes

Preserves Subunit Autonomy
Cost-Based: No, it is rule based
Negotiated: Yes

Other Factors
Market Price: No market may exist
Cost-Based:
Useful for determining
full-cost; easy to implement
Negotiated:
Bargaining takes time and
may need to be reviewed

General Guideline
Minimum transfer price
= Incremental costs per unit incurred
up to the point of transfer
+ Opportunity costs per unit to the selling division

General Guideline
Assume a perfectly competitive market,
with no idle capacity.
Transportation Division can sell all the crude oil
it transports to the external market in Seattle
for $23 per barrel.
($19 + $4) or ($13 + $2 + $8) = $23 = Market price

General Guideline
Assume that an intermediate market exists
that is not perfectly competitive, and the
selling division has idle capacity.
If the Transportation Division has idle
capacity, its opportunity cost of transferring
the oil internally is zero.

General Guideline
It would be $15 per barrel for oil purchased
under the long-term contract, or...
$19 per barrel for oil purchased and
transported from the independent
supplier in Alaska.

Incorporate income tax
considerations in
multinational
transfer pricing.

Multinational Transfer Pricing
IRC Section 482 requires that transfer prices for
both tangible and intangible property between a
company and its foreign division be set to equal
the price that would be charged by an unrelated
third party in a comparable transaction.

End of Chapter 22

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